The Impact of Financial Statement Audits on Non-Income-Increasing Misreporting : Evidence from Restatements

Extant evidence implies that managers rely on a variety of non-income-increasing techniques to manipulate earnings. However, prior research finds that the auditor is more likely to discipline firms against practicing income-increasing (II) earnings management due to its higher litigation and reputation risk, although it remains silent on whether the auditor also constrains non-income-increasing (NII) misreporting. Exploring the nature of NII misstatements, we first find that a significant portion of NII misstatements could have valuation implications. In analyzing the role that financial statement audits play in preventing NII misstatements, we find that the auditor exerting more effort reduces the likelihood of II misstatements, but has no perceptible impact on the likelihood of NII misstatements. Annual audits significantly reduce the probability that accounting mistakes are carried from quarterly reports to annual reports for II misstatements, but have minimal economic impact on NII misstatements. The lower audit efficacy over NII misstatements is more pronounced for those that do not impact net income. Further, we find that the asymmetric audit quality for II and NII misstatements is attributable to lower likelihood of detection of NII misstatements along with the lower likelihood of correction of detected NII misstatements as shown in prior research. Our research sheds lights on whether financial statement audits are effective at constraining NII misstatements, which is an important issue given that NII misstatements have become the most prevalent type of financial misreporting in recent years